In today’s volatile investment
climate, where market downswings of late have been as high as 10 percent in a
single day, many investors are looking to bonds for the stability of
fixed-income returns. The problem is, most dollar-denominated, credit-worthy
bonds pay interest of little more than 7 percent a year. If you seek higher,
double-digit yields, typically you’re looking at junk bonds which may carry
greater risk of default. Junk bonds are bonds with a credit rating of BB or
lower issued by companies without long track records of sales and earnings, or
by those with questionable credit strength.

An alternative for investors looking
for higher returns without dependence on equity investments, which tend to be
volatile, is to invest in the fixed-income securities of "special
situations" companies. Special situations companies are ones that have
undergone some kind of event or situation that has caused them to be
misunderstood by Wall Street. These may be companies with complicated pay-out
structures or uncertain cash-flow reimbursement streams. They may be new issues
or spin-offs not yet followed by the investment community, or companies in
industries experiencing negative publicity causing them to fall out-of-favor
with Wall Street. Such companies often offer bonds with high yields not
necessarily because they are a poor credit risk but rather because the facts
surrounding these companies may be obscure or difficult to understand without
detailed research. The more complex the situation, the more misunderstood it is,
resulting in lower purchase valuations and potentially larger rewards for those
able to correctly interpret the information.

Take a company like USN Communications.
Started in 1994 with the intent of being a competitive telephone access
provider, the company changed course in 1996 due to the high cost of developing
switching facilities and decided to become strictly a reseller. When it sought
financing in August of this year, it still had negative cash flow; furthermore,
with Wall Street mixed about telecommunications resellers as a group,
questioning whether they could make money on small spreads, USN had to resort to
high-yield, 14 5/8 percent bonds, coupled with options to purchase 11.1 percent
of the common stock, in order to entice investors. This despite the fact that
USN had $125 million in equity from major investors like Merrill Lynch Asset
Management, Chase Venture Capital, and Bankers Trust, along with comprehensive
agreements with major telephone providers such as Ameritech and MCI to resell
local and long distance service – hardly the credentials of a junk bond
issuer.

Or consider Iridium LLC, a company
developing a global telecommunications infrastructure highlighted by the
launching of 66 commercial satellites. As it was a young company, Iridium was
not followed by analysts from major Wall Street firms, and when it sought
financing for its multi-billion-dollar effort to provide state-of-the-art
telephonic paging and email capability to businessmen throughout the globe, it
issued 13 percent senior bonds along with warrants giving investors the option
to purchase five shares at $20 per share for every $1,000 bond. These attractive
yields were offered despite the solid underpinning of an equity partnership with
a worldwide consortium of leading industrial companies such as Sprint and
Motorola.

If Wall Street fails to recognize
companies like USN and Iridium, at least in the stages of their bond issues,
it’s because such companies – or, rather, their compelling stories -- are
not easy to identify. The stories behind young companies, or spin-offs, or
companies with complicated restructurings or companies in out-of-favor
industries are often too complex, or at times too obscure, to uncover. Smaller
institutions lack the resources to weed through these stories, and larger
institutions, not seeing a big enough pot at the end of the rainbow or not
perceiving that these companies are likely to become investment banking clients,
often decide against deploying their resources for the required detailed
research. The result can be overlooked high-quality companies offering
under-priced, high-yield bonds.

How does one learn of these companies?
One fund manager who dedicates a fund specifically to special situations,
fixed-income investments is Ernest "Doc" Werlin, manager of the High
View Special Situations Fixed Income Fund. Werlin’s fund has a joint venture
with Horizon Asset Management, the largest independent investment research firm
in the United States, to assist in identifying these investment opportunities.

It seeks to profit from the interest
paid on these companies’ bonds, plus any appreciation in the bond prices or
the prices of discounted equity positions attached to bond issues such as
warrants -- the right to buy a certain number of shares at a fixed price for a
specified period of years – or convertible bonds, which are options to convert
bonds to equity if the future value of the stock holdings are worth more than
the bonds. Some of Werlin’s other special-situations, fixed-income strategies
include making direct loans to companies at double-digit interest rates
(provided the borrowing companies also offer equity options or warrants in
exchange for the loan), purchasing high-yield bank loans that banks want to get
off their books at a discount, and providing bridge loans to companies prior to
an initial public offering – again, provided equity incentives are offered.

"Special-situations, fixed-income
investing provides a unique opportunity for investors to achieve steady returns
with little market correlation," Werlin explains. "Even in down
markets, investors profit from the bond’s interest payments, and the fact that
we invest in bonds with short time horizons means that even if bond prices drop,
investors get back their full investment -- plus the earned interest -- after a
relatively brief period of time."

Of course, the added bonus expected in
special situations fixed-income investing is that bond prices – as well as the
prices of equities -- will rise once Wall Street catches on to the mispricing
that has occurred by a company being under-researched, out-of-favor, or
misunderstood. The reasoning is that the more a special situations investment is
overlooked, the greater the gap between its current price and the price that
should eventually result from the recognition of the intrinsic value. Once the
investment community recognizes this gap, a company is re-rated, causing its
bond yield to drop and the bond price to go up. Furthermore, as such investments
are usually driven by events specific to a company or industry, they tend not to
be correlated to overall market trends.

Consider the case of Saberliner, Inc.,
whose bonds collapsed upon news that the company’s subsidiary had improperly
prepared the canisters that caused the ValuJet plane crash in Florida. Those
like Werlin who closely analyzed the situation saw that claims against the
subsidiary wouldn’t impact the parent because of sufficient insurance and
limited liability. When the market awoke to this reality, Saberliner’s bonds,
which had been marked down based on the market’s incorrect assessment of the
situation, surged in price (as did High View’s investment).

This, however, as mentioned, is only
the added bonus. The primary attraction of fixed-income, special-situations
investing for today’s cautious investor is its consistent returns without
undue dependency on an increasingly volatile stock market.